Index Fund – All we need to know about Index Fund

Can you have a long term strategy based on just passive indexing? No worries about active selection and portfolio management. Let us first understand what indexing is all about.

What is an index fund all about?

An index like the Nifty or the Sensex which is representative of the overall market forms the basis of an index fund. In India most indices are broad based and weighted based on floating stock. That means a company with more floating stock will get a higher weightage. While the SENSEX consists of a group of 30 stocks, the NIFTY consists of a group of 50 stocks. Let us now understand what an index fund is all about?

An Index fund is a mutual fund that benchmarks an Index and invests its entire corpus in the same proportion of the composition of that index. For example if RIL and HDFC Bank have a weightage of 4% and 5% in the Nifty then the Nifty index fund will buy these stocks in the same proportion too. Investing in an Index Fund is called passive investing since the job of the fund manager in this case is limited to replicating the Index and just managing the tracking error in the index fund to ensure that the fund is as reflective of the index as is possible.

What are some of the advantages of investing in an index fund?

Index fund investing has some unique advantages (we will come to the wealth creation aspect later). Let us look at some of the merits.

Index fund investing is a low cost approach to investing and this matters a lot because cost matters a lot in deciding your return on investment. The fund manager’s job is limited and no research team is needed for smart stock selection and portfolio flicking. The expense ratio of an index fund is around 1% in India compared to 2.5% for equity funds.

Just look at the Sensex to understand the returns that the index can give. As Sensex completed its 40th year, it has moved from 100 to 39,000. Or an investment of Rs.10,000 in 1979 would be worth Rs.3.90 crore today; an average annualized CAGR return of 18%.

Contrary to what a lot of active fund managers talk about, and what many investors tend to erroneously believe, index funds have generated good returns over time in line with the growth in economy and with much lower volatility and risk.

Indexing offers the best proxy for diversification because you have in front of you an index which is already a diversified portfolio. You don’t need to worry about correlations and auto correlations. It is an easy investment strategy with diversification.

Index fund investing is simple and extremely elegant. Investment in index fund can be done online with Infini MF app from Tradeplus just like an investor does online trading. If an investor is new to investing, indexing is an easy strategy to implement. That is because you get market related returns and early positive returns over other asset classes if held over a longer period of time.

But there are some challenges in investing index funds too

Indexing does sound simple but one must understand that there are some downside risks too to factor in. To begin with, index funds have low flexibility. There is nothing like leeway in asset allocation and investing since the index needs to be adhered. As a result fairly salivating opportunities tend to get missed out.

There is the risk of tracking error where the index fund may not reflect the actual returns the index. Any deviation is a risk, be it positive or negative. Tracking error arises because funds have to hold cash in their books, index keeps changing and index funds have their expense ratios which deviate from the index.

Bottom line: should you opt for index funds?

The concept may not have taken off in India but as alpha becomes tighter, more people will see the value of low cost index funds. Indexing will certainly become more attractive to investors in the future. Remember, that globally, fund managers struggle to beat the index. As an investor there are two challenges. Firstly, outperforming the index is tough. Secondly, as a mutual fund investor it is hard to predict which funds will outperform the index. That is where index funds really fit in.

Because they are passively managed, they do not indulge in trading actively. They only seek to match the index performance and hence expenses are low. And hence index funds often outperform the majority of actively-managed funds.

Like any investment, index funds involve risk. An index fund will be subject to the same general risks as the securities in the index it tracks. The fund may also be subject to certain other risks, such as Lack of Flexibility. An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index. Tracking Error-An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index. Underperformance. An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

Because index funds generally use a passive investing strategy, they may be able to save costs. For example, managers of an index fund are not actively picking securities, so they do not need the services of research analysts and others that help pick securities. This reduction in the cost of fund management could mean lower overall costs to shareholders. However, keep in mind that not all index funds have lower costs than actively managed funds. Always be sure you understand the actual cost of any fund before investing.